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WOLF BLITZER, CNN ANCHOR: Happening now: Barack Obama stares skeptical Democrats in the eye one week before he becomes president. Will the cajoling and arm-twisting pay off for him and for America's troubled economy? Hillary Clinton vows to bring smart power to a global hot spot, this hour, the would-be secretary of state under questioning about her policy and her husband's donors.

And an unprecedented test of America under attack. The outgoing and incoming administrations join forces for an exercise in mock terror.

I'm Wolf Blitzer. You're in THE SITUATION ROOM.

ANNOUNCER: This is CNN breaking news.

BLITZER: But we begin with the breaking news about one of Barack Obama's most important Cabinet picks. That would be the treasury secretary nominee, Timothy Geithner.

At issue right now, there's new information just surfacing, literally only moments ago, that Geithner failed to pay personal taxes and check the immigration status of a housekeeper.

Let's go straight to our senior White House correspondent, Ed Henry, who is watching this story for us.

All right, give us the background. Tell us what we know.

ED HENRY, CNN WHITE HOUSE CORRESPONDENT: Well, Wolf, a meeting, a critical meeting, just broke up on Capitol Hill. We're told by transition officials that Tim Geithner, the designate to be treasury secretary, requested the meeting himself because of some sharp questions that are being raised now by senators on the Finance Committee.

They will be the ones in charge of his confirmation. Essentially, there are two issues, that essentially he went behind closed doors to explain that he had made in the words of transition officials a common tax mistake while he worked at the International Monetary Fund. This was before he was at the New York Fed, of course, several years ago, that basically he -- they are claiming that he paid all of his income taxes on his IMF income, but made a common mistake on his tax returns with regard to self-employment taxes. He voluntarily corrected that mistake, according to transition officials, as soon as it was discovered years ago. And they are also saying that this was found by the presidential transition team. But what we don't know right now is why this was just learned by the Senate Finance Committee, why, if this was some sort of problem that was dealt with years ago about him not paying taxes and then correcting it later, why that was not dealt with up front, so that it would not be a surprise to senators.

Secondly, we're told that senators on the committee are now raising questions about a housekeeper that Tim Geithner and his wife employed to clean their home from 2004 to 2005. Now, transition officials are telling us the Geithners verified that they had a current what's called an employee authorization document at the time that this housekeeper was hired, and that Mr. Geithner, according to transition officials, was unaware that for three months before she stopped working for them, that her authorization essentially had expired, Wolf.

Nevertheless, they say she continued to reside legally in the U.S., that she was married to a U.S. citizen, this housekeeper, and she was granted a green card a few months later.

Some critical information about what this means for the nomination of Tim Geithner, just told by our congressional producer, Ted Barrett, who was there when this meeting broke up on Capitol Hill that Chairman Max Baucus of Montana came out and said that these are serious questions the committee is looking at, but he stressed that this does not rise to the level of disqualification for Tim Geithner.

The Republicans who left that meeting, though, did not comment to reporters thus far. So, we still have to see what they have to say. One last critical point is that Robert Gibbs, the incoming White House press secretary, has just put out a written statement, saying -- quote -- "The president-elect chose Tim Geithner to be his treasury secretary because he's the right person to help lead our economic recovery during these challenging times. He's dedicated his career to our country and served with honor, intelligence and distinction. That service should not be tarnished by honest mistakes which upon learning of them he quickly addressed."

"He made a common mistake on his taxes," Robert Gibbs continues, "and was unaware that his part-time housekeeper's work authorization expired for the last three months of her employment. We hope that the Senate will confirm him with strong bipartisan support so that he can begin the important work of the country" -- again, a written statement from Robert Gibbs, the incoming White House press secretary.

Obviously, a lot of questions here again about the vetting process so, quickly after Bill Richardson's nomination to be commerce secretary ran into peril and then obviously was withdrawn, though, right now, the transition team sticking behind Tim Geithner and insisting that everything is fine, they are telling me privately, and they are going to work this out with the Senate Finance Committee.

This is another political problem, Wolf, that the Obama team did not need right now.

BLITZER: It's a headache. There's no doubt about that.

Ed, I want you to stand by.

I want to bring in our senior political analyst, Gloria Borger.

A lot of us remember 16 years ago, during the first few weeks of the Bill Clinton administration, the names Kimba Wood, Zoe Baird, housekeepers, didn't pay taxes, their status. Are we about to go through that once again?

GLORIA BORGER, CNN SENIOR POLITICAL ANALYST: Well, and a lot of the people who work in the Obama transition remember that personally from the Clinton administration, Wolf, because they went through it with Bill Clinton.

They are saying -- I just got off the phone with a senior transition official. He says, for the tax issue, the personal tax issue for Tim Geithner, he called it a minor technical mistake. And as Ed Henry was just saying, this is something that's an issue for International Monetary Fund employees, because, technically, they are considered self-employed, and they don't realize that they need to pay a self-employment tax, in addition to their regular income taxes. That was his mistake.

As for the housekeeper, the question is, can there be a double standard for Tim Geithner if it hurt Kimba Wood and Zoe Baird? And those are going to have to be questions that the Senate is going to answer. This senior transition official told me that they believe that they have the support of Orrin Hatch and they believe they have the support of Debbie Stabenow, senators.

But they are saying and he said to me -- and I quote -- "We don't want to lose this important a person at this time of economic crisis in our country over this kind of" again what he called minor technical matters.

BLITZER: And he does have an enormous amount of experience, not only at the Federal Reserve in New York.

BORGER: Yes.

BLITZER: But he served in the Treasury Department under Larry Summers, when Larry Summers was the treasury secretary, during the Clinton administration.

BORGER: Yes. So, he is somebody with a wealth of experience, not only on the Fed, but also in federal government here in Washington.

And, you know, they believe that -- that he is the person for this job. And it's clear that what they are trying to do is sort of tamp it down immediately, go to the senators, say, look, we have this mistake. We want to let you know about it right now. And then you can figure out how to deal with it. We will answer all of your questions.

They are erring on the side of disclosure.

BLITZER: And people will ask questions about the vetting process of the Obama transition team...

BORGER: And why...

(CROSSTALK)

BLITZER: ... why is this only coming out now.

BORGER: Right.

BLITZER: Did they know about it when they were asking him, you remember, that long questionnaire they asked everyone to fill out?

BORGER: We do not yet know the answer to that question. We will find out.

BLITZER: We will stay on top of it. Gloria, thank you.

Ed Henry at the White House.

Also, the president-elect is putting his prestige on the line today in an early tug of war with Congress over federal bailout money. And his choice for secretary state is putting her diplomatic skills to the test as well in her first big interview for the Cabinet job.

SEN. HILLARY RODHAM CLINTON (D-NY), SECRETARY OF STATE NOMINEE: I assure you that, if I am confirmed, the State Department will be firing on all cylinders.

DOUGHERTY: No fireworks, though, as the United States' future top diplomat fielded friendly questions from her fellow senators. SEN. JOHN KERRY (D), MASSACHUSETTS: Do you plan personally to engage in personal diplomacy with Iranian officials at a high level in the near term?

CLINTON: We are not taking any option off the table at all. But we will pursue a -- a new, perhaps different, approach that will become a cornerstone of what the Obama administration believes is an attitude toward engagement that might bear fruit.

DOUGHERTY: On Gaza, no giving up on peace, but no negotiations with Hamas, unless it recognizes Israel and renounces violence. Clinton said the U.S. will apply pressure wherever it may be needed, but using what she calls smart power.

CLINTON: We will lead with diplomacy, because that's the smart approach. But we also know that military force will sometimes be necessary, and we will rely on it to protect our people and our interests when and where needed, as a last resort.

DOUGHERTY: As secretary of state, Hillary Clinton wants to take back responsibilities that, under the Bush administration, were taken over by the Defense Department, things like nation-building. To do that, she wants more resources and funding for the State Department.

CLINTON: But, really, it's all hands on deck. We have a lot of work to, in my view, kind of repair damage and get out there and -- and present America as we know we are.

(END VIDEOTAPE)

DOUGHERTY: So, despite that warm reception, there were some tough questions coming on the issue of her husband's global charitable fund.

Dick Lugar, the ranking Republican, says that there could be a perception problem internationally. And he wants the foundation to stop taking new international donations. Hillary Clinton won't go that far. She says the existing agreement between the Obama team and the -- and the foundation is as good as you're going to get -- Wolf.

BLITZER: But, despite all of those questions, there's no doubt she's going to be confirmed when -- when the dust settles. Is that right, Jill?

CAFFERTY: Do you suppose there's a political career down the road for that young woman?

BLITZER: Wouldn't be surprised.

CAFFERTY: I will bet you. Yes.

All right, it's official. This is -- what a bizarre story. Roland Burris is going to be sworn in and officially seated in the U.S. Senate later this week. He will fill the seat vacated by president-elect Obama.

It comes after a circus of events that began with Illinois Governor Rod Blagojevich allegedly trying to sell Obama's Senate seat. Then, he refused, as he does to this day, to resign the governorship. Last week, Blagojevich was impeached by the Illinois legislature.

But, in a brazen show of arrogance, and perhaps as a way of calling Senate Majority Leader Harry Reid's bluff, Blagojevich went right ahead and appointed Roland Burris, as promised. The Senate refused to seat him.

When Burris was named, Senate Majority Leader Harry Reid and others quickly said they would reject anyone appointed by Governor Blagojevich, sort of a chest-beating, machismo-type moment: He's not going to our Senate, because Blagojevich is dirty.

Senator Dick Durbin, who is from Illinois and the number-two ranking senator, initially said the fate of the vacant seat should wait until Blagojevich was removed from office.

No shortage of lawmakers issuing statements and rushing to get in front of the cameras to speak their minds. But look what can happen in a week. Burris met behind closed doors with Reid. Democratic senators suddenly changed their tune. And now they will welcome Burris with open arms as their new and beloved colleague.

Here's the question: Why did Harry Reid and Dick Durbin cave in and agree to seat Roland Burris as Obama's Senate replacement?

Go to CNN.com/caffertyfile. Post a comment on my blog -- Wolf.

BLITZER: Thank you, Jack.

There's never been anything like it in the history of presidential transitions, the old administration and the new one preparing for what's being described as a doomsday scenario. Plus, a week before he takes office, Barack Obama's presidential clock is ticking. How long will Americans give him to bring about real change.

And the former British Prime Minister Tony Blair, he sits down with me. He tells me why he's convinced the Obama administration can focus on Middle East peace without being distracted by the economy.

Stay with us. You're in THE SITUATION ROOM.

(COMMERCIAL BREAK)

BLITZER: And now to the president-elect confronting members of his own party one week before his inauguration. Many Democrats are demanding to know how Mr. Obama will spend billions of dollars in bailout money once he's in charge.

DANA BASH, CNN CONGRESSIONAL CORRESPONDENT: We know that there was a spirited discussion inside the Democratic Caucus with Barack Obama there. And he made, I am told, a very hard pitch for them to allow him to have this money, this $350 billion of the remaining fund to bail out Wall Street. And he said that he doesn't want to do this to his fellow Democrats, but he feels like he has no choice.

And he also warned them that, if they send him a resolution disapproving of it, basically saying that he can't use the money, he will have to use his very first veto at the -- in the beginning days of his -- of his administration. And that is certainly something he made clear he does not want to do.

But, you know, I'm told that, inside this meeting, he got an earful from Democrats. They said to him the same thing that they told us, many Senate Democrats, all throughout the day today. And that is that this program has been so mismanaged, from their point of view, and so unpopular, they say, even though it is their fellow Democrat asking something big from -- from -- from them, they are not sure they can do it.

(BEGIN VIDEO CLIP)

SEN. BEN NELSON (D), NEBRASKA: Well, I'm -- I'm -- I am undecided. But I am -- I'm certainly not leaning in favor of doing it, not until I have more information.

And, even then, I don't know if I can get enough information. I understand that the -- the president-elect wants to move forward. And I would like to be supportive, but I'm not going to make -- I'm not going to be pushed into a quick judgment on this, given all the circumstances. People back home generally didn't want the first go-round. And I'm not going to jump out in front of a train on this second one.

(END VIDEO CLIP)

BASH: Now, that is Senator Ben Nelson of Nebraska, who voted for this bailout the first time around. And you heard him very skeptical there.

I can't tell you how many Democratic senators, Wolf, told me today that they feel that they are really torn between their constituents, who are outraged about the idea of giving so much money, so much more of their money, to Wall Street, and torn between that and what the president, their new president, is asking of them.

And I'm also told, in that meeting that just ended a short while ago here, Senator Chris Dodd, the chairman of the Banking Committee, stood up and made very clear the political stakes here for them and, more importantly, for Barack Obama, made clear, look, you don't want this to happen. You don't want Barack Obama to come into office, and the very first thing that he would do is -- is use his veto pen and say, sorry, I need to do what I'm going to do here, and you -- you're not going to stop me, fellow Democrats.

BLITZER: And, as you say, Dana, it's -- it's extraordinary to -- to even think that a president-elect could already be threatening a presidential veto during his transition. He's not even in office yet. It underscores the points you are making.

Dana, thanks very much.

BASH: Thank you.

BLITZER: Struggling to find a job, watching life savings dwindle -- with so many Americans ready to turn their lives around, president- elect Obama has the tide rolling with him right now. So, will it last?

Our senior political analyst, Bill Schneider, is following this story for us.

Bill, you have studied presidents and American attitudes, public opinion attitudes, for a long time. How long will the voters give president-elect Barack Obama to show real improvement in the economy?

WILLIAM SCHNEIDER, CNN SENIOR POLITICAL ANALYST: Well, Wolf, the deadlines are set by the political calendar, which, you know, is kind of like an academic calendar.

(BEGIN VIDEOTAPE)

SCHNEIDER (voice-over): President-elect Obama urged patience on the economy in an exclusive interview with ABC News' "This Week" with George Stephanopoulos.

SCHNEIDER: How long will the voters give him? Look at the experience of other new presidents who got elected in bad times. When Ronald Reagan took over, the unemployment rate was just over seven percent. When Bill Clinton took over, the unemployment rate was just over seven percent.

What's the unemployment rate now, when Barack Obama is about to take over? Just over seven percent. During Reagan's first two years, the economy got a lot worse, double-digit unemployment by the end of 1982, at the time of the midterm election.

President Reagan tried to limit the damage.

(BEGIN VIDEO CLIP)

RONALD REAGAN, FORMER PRESIDENT OF THE UNITED STATES: ... by staying the course.

(END VIDEO CLIP)

SCHNEIDER: His party lost 26 House seats, but no Senate seats. It was a warning. The voters were getting impatient.

Things got better during the next two years. Unemployment went down to where it was when Reagan took office. And inflation, which was a huge problem in those days, was cut by two-thirds. Republicans said it was morning in America. President Reagan was easily reelected.

During Clinton's first two years, unemployment went down, but the voters still turned against the Democrats in 1994 and threw them out of power. What were they angry about? Clinton's health care plan, tax hikes, gays in the military, the assault weapons ban. The economy, not so much.

But unemployment continued to go down, and, after four years, it paid off. Clinton was easily reelected.

Conclusion? Obama can expect midterm grades after two years and final grades at the end of four.

(END VIDEOTAPE)

SCHNEIDER: Another conclusion: Grades are based on a lot of subjects, not just the economy. In 1982, Reagan's economic grades were terrible, but he was doing well in other subjects. In 1994, Clinton was doing pretty well on the economy, but other subjects brought his party down -- Wolf.

BLITZER: Dr. Bill Schneider with a little academic exercise.

Appreciate it very much. Thank you.

(CROSSTALK)

BLITZER: Bill Schneider, as many of our viewers know, has a Ph.D. in political science, so he knows what he's talking about.

Serious problems around the world await Barack Obama.

(BEGIN VIDEO CLIP)

BLITZER: Are you concerned that President Obama and his secretary of state, Hillary Clinton, and others won't be -- won't have the energy, the time to devote to the Israeli-Palestinian conflict that you would like to see?

(END VIDEO CLIP)

BLITZER: The Middle East special envoy, Tony Blair, the former British prime minister answering that question in an interview with me. And he gives his prescription on how to stop the violence between Israel and Hamas.

And former President Jimmy Carter gets an unfortunate title: victim of crime. We will explain -- right here in THE SITUATION ROOM.

(COMMERCIAL BREAK)

(NEWS BREAK)

BLITZER: Meanwhile, a very serious story we're following right now: more blood flowing in the Middle East. Here's a question: How can the violence be stopped?

(BEGIN VIDEO CLIP)

TONY BLAIR, FORMER BRITISH PRIME MINISTER: There could be an immediate cease-fire, if people want it to happen. But it's got to be fully respected on both sides. Otherwise, you know, we're back to where we are.

(END VIDEO CLIP)

BLITZER: The special Middle East envoy, Tony Blair, sits down with me here in Washington. You are going to hear his prescription for ending the crisis between Israel and Hamas.

And we're following the breaking news. Barack Obama could see the first major controversy over one of his nominees. Treasury Secretary Nominee Timothy Geithner failed to pay personal taxes and check the immigration status of a housekeeper.

Stick around. You're in THE SITUATION ROOM.

(COMMERCIAL BREAK)

BLITZER: To our viewers, you're in THE SITUATION ROOM. Happening now: The nation's capital gets ready for one of the biggest problems it's ever seen, the inaugural crowd. It's going to be huge. And, if there's a crisis, you can see why any teenager can show you the -- the best way to communicate. We will have details.

And it turns out that disappearing pilot who allegedly faked his death lived in a multimillion-dollar home, but he may have had a big reason to hide.

I'm Wolf Blitzer. You're in THE SITUATION ROOM.

"Too many people have died" -- that's a quote from the United Nations secretary-general, Ban Ki-Moon, on the war between Israel and Hamas. He's headed to the region to press for an immediate cease- fire.

Fighting, though, rages, as the Israeli military pushed into the farthest it's -- it's done so far into Gaza City since the conflict began. And Hamas fired another 15 rockets into Israel.

Tony Blair, the Middle East special envoy, is concerned, deeply concerned about the violence. Today, President Bush awarded him the Presidential Medal of Freedom, America's top civilian honor.

I spoke with Tony Blair just before that.

(BEGIN VIDEOTAPE)

BLITZER: Prime Minister, thanks very much for joining us.

Let's talk about a cease-fire or a truce between the Israelis and Hamas. Is it going to happen?

BLAIR: I think as we speak, it hangs in the balance somewhat. I mean, I hope very much as a result of the negotiations over the next few days, we can put together an immediate cease-fire, but one that lasts and one that's obviously respected on both sides.

BLITZER: What's the key stumbling block right now?

BLAIR: The key stumbling block is to make sure that on the one side, we can stop with a credible plan the smuggling of weapons and arms, rockets coming into Gaza, which Hamas then use to fire on Israel.

BLITZER: And they come in from Egypt?

BLAIR: And they come in through the Egyptian border. And then secondly, we need, obviously, to reopen Gaza to the outside world, reopen the crossings, so that material can come in for the Gazan people.

Now, those two things may sound relatively simple, but there's a lot of complication around both of them. But that's what we're working to fix. And from the conversations I had in Cairo yesterday with the president of Egypt and others, you know, I think the Egyptian initiative is the only -- it's the only game in town, frankly, to bring this to a conclusion sooner rather than later.

BLITZER: The Israelis say it's relatively simple. They just want the rockets, the mortars, the missiles to stop coming in from Gaza into Israel.

BLAIR: Yes. And at one level, it is very simple. But actually, the technical, the logistical, the enforcement means to do that is hard.

I mean, these are tunnels, hundreds of them, that have existed for a long time. Smuggling has been going on through that -- through that Egypt/Gaza border for a very long time. Indeed, to stop that is extremely important because then Israel can say, well, we've protected our security or enhanced our security. But it's not an easy thing to do.

BLITZER: But do you have a commitment from Hamas through intermediaries that they will stop firing rockets into Israel?

BLAIR: Well, this is the other issue, is that even if Israel accepts this plan, will Hamas? Now, the Egyptians are also talking to them and, again, there are various issues that the two sides are trying to get sorted out. But, you know, let's be absolutely clear about this.

There could be an immediate cease-fire if people want it to happen. But it's got to be fully respected on both sides. Otherwise, you know, we are back to where we are. And then after that, incidentally, what is essential is to realize that any cease-fire, whatever people say, will only be temporary unless we deal with the fundamental and underlying problem.

BLITZER: Will there be some sort of international monitors, U.N. monitors, Egyptian, Palestinian Authority, other countries involved in making sure that the terms of this cease-fire are honored?

BLAIR: Well, that's one dimension of the discussion that's going on. I mean, I think there is a role for the international community, but obviously, they will only come in in a permissive environment.

BLITZER: And what will they do? Will they be on the border between Gaza and Egypt and monitor all those tunnels to make sure that there's no smuggling going on?

BLAIR: Yes, there is discussion about whether that should happen or not. And as I say, just at the moment, this is obviously at a delicate and sensitive stage.

But the whole point is to make sure whatever happens, the plan to end the smuggling is a credible plan. And that's the only way we're going to get the cease-fire. Otherwise, this will...

BLITZER: As we speak right now here in Washington, at the British Embassy, do you believe there will be a cessation of the fighting in the next few days? BLAIR: I mean, I wish I could say yes, but, I mean, truthfully, I think it hangs in the balance. As I said to you, I think it's -- there is a proposal that is there. It's on the table. But at the moment, there are still issues of detail to be sorted out, but also there's a question of whether the sides will accept.

And my own view is that Israel will accept a credible plan to stop the smuggling and will allow the reopening of the crossings. I mean, their sole preoccupation, in a sense, is to prevent the threat that, as they see it, is coming from Gaza to the Israeli towns and cities in and around Gaza, where the rockets are fired continually.

BLITZER: The U.S. is about to have a new president, a new administration. They will be focusing enormously on the economic crisis, which could be the worst since the Great Depression.

Are you concerned that President Obama and his secretary of state, Hillary Clinton, and others won't have the energy, the time to devote to the Israeli-Palestinian conflict that you would like to see?

BLAIR: No. Actually, I'm not concerned about that.

I mean, I think that -- I mean, look, one of the things about being president or being prime minister is you have to deal with -- you know, you deal with what's on the agenda. You can't say, well, I'll push this problem away.

And in any event, I think both the president-elect and Senator Clinton made it absolutely clear, they regard this as a priority. So, no, I don't think that's a concern.

BLITZER: Have you spoken to both of them?

BLAIR: I have. And both have made it absolutely clear that they regard this as a priority, understand it's important, and want to move it forward.

BLITZER: We're out of time, but a quick question. You're about to get the Medal of Freedom from the president of the United States. You stood with him during some very difficult times when he was severely criticized for his handling of the war in Iraq. You were severely criticized as well.

What goes through your mind on a day like today when you are about to be honored?

BLAIR: I think for me, my reflection is all those people that worked with me over this time, particularly in our armed forces, you know, whether it's when we were pursuing military action in Kosovo, in Sierra Leone, Afghanistan, Iraq, obviously, or peace in northern Ireland. And I came into power in 1997, expecting to focus on a very much domestic-oriented agenda, and found myself, because of events, not least, September the 11th, focusing on very much on a foreign policy agenda.

That's the way it is. But I see this really as -- for me, it's about the people who work with me and their sacrifice, and their commitment.

BLITZER: Any final word of advice for Barack Obama?

BLAIR: Look, I don't think he needs advice from me or anyone else. I mean, I just think the most important thing for the international community is, yes, let's rejoice at this great new moment for America, a fantastic thing for America and for the world. But let's, having rejoiced, then get on and actually help the guy, because these are tough jobs, they require tough decisions, and he's going to need partners and friends, as well as cheerleaders.

BLITZER: And you'll be there with him?

BLAIR: I'll be there doing whatever I can to help, of course.

BLITZER: Prime Minister, thanks very much. And congratulations.

BLAIR: Thank you.

(END VIDEOTAPE)

BLITZER: One week before the inauguration, a doomsday scenario. And the Bush and Obama camps are facing it together.

Cabinet secretaries who go on to become lobbyists. A new report takes aim at the so-called revolving door in the White House.

And later, Barack and Michelle Obama before they were America's new power couple. Candid portraits of a young husband and wife revealed.

Stick around. You're in THE SITUATION ROOM.

(COMMERCIAL BREAK)

BLITZER: They're truly unforgettable scenes of death and devastation, terrorists unleashing hell during 9/11, 2005's London bombings, and bombings in Madrid in 2004. The United States is determined never, never to let this happen again. So today, officials at the highest levels of government did something they've never done before. It's truly unprecedented.

Our White House Correspondent Dan Lothian is watching this story.

It's called a doomsday drill, Dan, and it happened today.

DAN LOTHIAN, CNN WHITE HOUSE CORRESPONDENT: That's right, and it really is designed to protect the American people.

I should point out that this tabletop exercise was in no way connected to any known or imminent threat. The White House saying it was part of quarterly exercises they've been conducting.

What is different though this time around is it's the first time that team Obama and then the Bush team have sat down together to go over the what-ifs. (BEGIN VIDEOTAPE)

LOTHIAN (voice-over): It's an unprecedented transition moment -- America's transportation infrastructure under attack in a test for three hours. Bush cabinet and White House officials sweating the details with key members of the incoming Obama administration.

JOSH BOLTEN, WHITE HOUSE CHIEF OF STAFF: These things are never perfect, but they're good learning exercises.

LOTHIAN: In this hypothetical attack, bridges, roadways, rail service and ports in several American cities are targeted by terrorists using improvised explosive devices, or IEDs.

TONY FRATTO, WHITE HOUSE SPOKESMAN: It's the opportunity to try to best anticipate the unexpected, and you do that with a room full of people, talking through what your actions would be.

LOTHIAN: Rahm Emanuel, Obama's choice for chief of staff, says this is just another example of a seamless transition that's preparing the incoming administration and ultimately protecting the American people.

RAHM EMANUEL, INCOMING WHITE HOUSE CHIEF OF STAFF: There is no higher task to any administration than protecting the American people, whether that's threats from terrorism or natural disasters.

LOTHIAN: In reflecting on his eight years in office, President Bush has been quick to point out that there hasn't been another terrorist attack on U.S. soil since 9/11.

GEORGE W. BUSH, PRESIDENT OF THE UNITED STATES: We've protected this country from harm, and we did so by providing tools for professionals, as well as asking our military to do hard work, which they have done time and time again.

LOTHIAN: But Mr. Bush and his outgoing team know the threat of terrorism remains and will be a major challenge for the incoming administration.

BOLTEN: We want this new team to be as successful as they possibly can be, especially in the areas of national and homeland security.

(END VIDEOTAPE)

LOTHIAN: Rahm Emanuel pointed out today that while Democrats and Republicans have often clashed over policy differences, there is no argument when it comes to protecting the American people -- Wolf.

BLITZER: Dan, thanks very much.

The Independent U.S. Senator Bernie Sanders of Vermont, the only U.S. state that President Bush has not visited, has taken issue with a new painting of President Bush in the National Portrait Gallery here in Washington. Let's go to our Internet reporter, Abbi Tatton.

Abbi, why is the Senator writing these letters?

ABBI TATTON, CNN INTERNET REPORTER: Wolf, Senator Bernie Sanders' problem is not with the portrait itself, but with this accompanying label explaining to visitors Bush's presidency was "marked by a series of catastrophic events that included the attacks on September the 11th, 2001, that led to wars in Afghanistan and Iraq."

Well, that led to Independent senator from Vermont to put pen to paper. "The notion," he wrote the Natural Portrait Gallery, "that 9/11 and Iraq are linked or that one led to the other has been widely and authoritatively debunked."

Senator Sanders urged them to reconsider the text. And the National Portrait Gallery has now agreed, saying their intention was to remind viewers of defining episodes of the Bush presidency, rather than imply a causal connection. That offending section led (ph) to will be deleted and Senator Sanders is invited for a personal tour of the gallery -- Wolf.

BLITZER: And it's a beautiful gallery, indeed.

All right. Thanks, Abbi, very much.

A setback today in Barack Obama's relatively smooth ride to the White House. The man he nominated for one of the most important positions, the treasury secretary, accused in some money trouble. We're picking apart all of this. What's going on?

Our "Strategy Session" coming up.

And remember when immigration was the hot-button issue? Ahead, why calls for reform may not be answered for a while.

Stay with us. You're in THE SITUATION ROOM.

(COMMERCIAL BREAK)

BLITZER: Back to the breaking news this hour. Information coming into THE SITUATION ROOM on the treasury secretary nominee, Timothy Geithner, and what the Obama camp is calling his honest mistakes. At issue right now, his taxes and his housekeeper's immigration status.

Let's bring back our senior political analyst, Gloria Borger.

Gloria, you're making phone calls. What else are you learning about this?

BORGER: Well, I'm talking to a bunch of transition officials, Wolf. And they are saying essentially that this is a glitch when it comes to the housekeeper. They are saying he did everything right. First of all, she was here on work authorization. She was a once-a-week housekeeper. He paid all of her back taxes, they say, that he asked -- all of her taxes. That he asked for documentation and he got it.

So this is not an issue, for example, of Kimba Wood or Zoe Baird. This is somebody he employed, paid her taxes.

Here's the glitch. You are supposed to ask annually whether this person still has their documentation.

She was having a child, was at the end of her tenure. There was a three-month period where he did not ask, and that is the period where she was not here legally. So they make the case that this is not a Zoe Baird kind of issue. In fact, just a glitch.

BLITZER: All right. And on the -- I don't know if Gloria is hearing me.

BORGER: I do. I hear you now.

BLITZER: You do hear me? All right.

On the other issue of the personal taxes that he failed to pay, what happened on that front?

BORGER: Well, and again, this is from being pieced together from a group of transition officials I've spoken with, that he did work for the International Monetary Fund, Wolf. And there is some ambiguity there, they say, about your taxes because you do -- you have to pay your taxes, but also, you have to file what is called an S.E., a self- employment tax, to pay Medicare and Social Security taxes.

At some point during his tenure there, after four years, I was told, he realized that he had not paid some of those taxes. He went to them and he said, I've got to do this, and paid for two years back taxes.

When the vetting took place now for him to become secretary of the Treasury, they discovered that, in fact, he needed to pay four years of those taxes. So there were two additional years which he has paid back taxes with penalty and with interest.

I'm also told by transition officials that all of this documentation has been in the hands of the Finance Committee, that he has explained it all to them.

Peter, a big deal, little deal? We're talking about those back taxes that he paid later of $30,000 or $40,000.

PETER FENN, DEMOCRATIC STRATEGIST: Yes, I think it's much ado about nothing, Wolf. I mean, look, the fact is the self-employment tax is something a lot of people don't know about. He paid it. He got it behind him. I think it's all right.

And the other issue is that he was paying his taxes on his housekeeper. She was married to an American citizen. There was that period, I guess, where her green card had lapsed. But, you know, this doesn't seem at all to be in the same category as Kimba Wood or Zoe Baird.

BAY BUCHANAN, REPUBLICAN STRATEGIST: Wolf, I'll tell you what concerns me. He has said that he didn't know about the self- employment, and that can happen to any of us, even though he is an expert in this area. But then he found out that he should do it for two years.

At that stage, well, how is it he didn't know he should do it for four years? Who told him, oh, it's only good for two years, and then now he learns it's four years? That tells me that there could be more to this story.

He is -- secretary of treasury is what he's hoping to be. That's Caesar's wife (ph). That person has to have been completely honest with our tax system. I think it's an issue that should be studied in a little bit more depth.

BLITZER: I assume the Senate Finance Committee, which has to confirm him, is going to go through all of the paperwork and make sure that they are happy with it.

FENN: Absolutely, Wolf. And they're going to ask him about it and they're going to go through it very thoroughly.

BUCHANAN: As well they should.

FENN: I think the question here is, was there an effort to not pay taxes? Clearly, that is not what's being charged.

BLITZER: All right.

(CROSSTALK)

BLITZER: All right. We're going to follow this story.

I want to move on, read to you a line from Cardinal Roger Mahoney, in the "Los Angeles Times," saying, "We cannot accept the toil and taxes of immigrants while relegating them to a permanent underclass subject to abuse and exploitation. Immigration reform must be addressed sooner rather than later."

He and others want the new Obama administration to take up comprehensive immigration reform, what John McCain tried to do and Ted Kennedy, right away.

BUCHANAN: And he would be foolhardy to do it. And I think the president-elect is a lot smarter than that, and so are his people.

They saw what happened. This is extremely divisive.

You want to get energy going in this country against Barack Obama, start talking to amnesty for people that are here illegally at a time when we have rising unemployment in huge numbers. This is not the timing at all to discuss that with the American people, unless he really wants to have some real battle going on.

BLITZER: Is this one of those issues he has to defer because he has a big economic crisis and foreign policy crises?

FENN: Sure. Sure, absolutely Wolf, unless he get Pat Buchanan and Bay Buchanan on board to work on this. No, and I think McCain doesn't want to take it on right now either.

The other thing I think though that you will see is, you know, there's a question of whether illegal immigrants should have lawyers. I think he'll allow that. I think you're not going to see a huge number of raids on businesses right away. So I think the idea is to keep it cool, calm, slow it down, deal with it later.

BUCHANAN: But on one area that he really is going to have to take a look, and that is the border, securing that border. The violence on the other side has escalated to such enormous -- it's as brutal as we can possibly imagine and it's beginning to come across the border. He's got to make certain that doesn't happen.

BLITZER: The former border governor, Janet Napolitano of Arizona, will be the homeland security secretary. She'll have a mission ahead, no doubt about it.

BUCHANAN: She has been opposed to the fence in the past. Hopefully she's learned her lesson.

BLITZER: We'll she was she does.

All right, guys. Thanks very much.

FENN: Thanks.

BLITZER: Barack Obama has certainly struggled to kick the habit. Might he get some anti-smoking help from within his administration?

And Hillary Clinton's own team of rivals, why she's surrounding herself with men and women who are as strong as she is in many respects.

And we also take you inside the president-elect's hard sell to fellow Democrats who have a bad case of bailout burnout.

Stick around. You're in THE SITUATION ROOM.

(COMMERCIAL BREAK)

BLITZER: On our Political Ticker right now, one of Barack Obama's latest hires could possibly help him in his struggle to kick the smoking habit. The president-elect has named the leader of an anti-smoking campaign to serve as deputy secretary in the Health and Human Services Department. That would be Bill Corr, the executive director of a group called Campaign for Tobacco-Free Kids.

Let's go back to Jack. He's got "The Cafferty File" -- Jack.

CAFFERTY: I was a three-pack-a-day smoker until 20 years ago and quit when I had a collapsed lung. I quit drinking and smoking in the same year. And I think quitting smoking is maybe the tougher of the two. I hope our new president can get off those.

The question this hour -- excuse me -- still have the cough, though: Why did Harry Reid and Dick Durbin cave in and agree to seat Roland Burris as Obama's Senate replacement?

Nick in New York writes: "Senators Reid and Durbin 'mis- underestimated' Blagojevich's political acumen and Burris' ego. Their bluff was called. The 'playas' got played."

Greg -- pardon me -- in Cabot, Arkansas: "A Democrat seated in the Senate is better than a Democrat candidate in a special election."

Kyle in Washington: "Because they didn't have a legal leg to stand on. Regardless of whether or not you think Governor Blagojevich is the anti-Christ, he has the constitutional authority to appoint Senator Obama's replacement."

I just wish Governor Blagojevich had chosen Oprah.

Brian in South Carolina: "I think it's because President Obama asked him to not let this become a distraction. Can you imagine Congress having a contest over this guy when they should be debating and voting on a stimulus bill that should have been implemented yesterday? Frankly, I don't care if he bought the Senate seat or not, but I hope he saved his receipt, because Blagojevich is going down."

Anthony in Wildwood Crest, New Jersey: "This happened for several reasons, Jack. A tainted black Democrat better than a White Republican any day. He's a vote and he is now in the fold. With the strides that Obama's made, locking the black man out of the party just wouldn't look good, now would it? He is a pawn, but at least he's getting a seat at the table."

And Don writes: "Why did Durbin and Reid cave? Habit."

If you didn't see your e-mail here, you can go to my blog at cnn.com/caffertyfile. Look for yours there among hundreds of others.

Did you ever smoke, Wolf?

BLITZER: In high school I tried it a little bit. Didn't like it. A little bit in college, but quit. That's a long, long time ago. Thank God I did.

CAFFERTY: Any other nasty habits you want to talk about? BLITZER: Yes, probably I did, but we'll get into that later.

(LAUGHTER)

BLITZER: Thanks, Jack.

CAFFERTY: OK.

BLITZER: And to our viewers, you're in THE SITUATION ROOM.

Happening now, Barack Obama visits Capitol Hill to personally appeal for the bailout involving billions of dollars he says needed to fix the economy. Why some fellow Democrats fear they'd be throwing good money after bad.

Also, more on the breaking news about Barack Obama's cabinet picks. Word that the nominee for treasury secretary failed to pay some personal taxes. We've got reaction from the Obama transition team.

And this. She calls them, and I'm quoting now, "bored, anonymous and pathetic." An angry Sarah Palin takes on the bloggers and she says, yes, you can see Russia from Alaska.